What is Liquidity Premium?

A liquidity premium is compensation that is given to investors to encourage investment in assets with poor liquidity. Conversely, a highly liquid asset has high trading volume and is easily converted into cash without affecting the asset's price. For example, long-term bonds may typically have poor liquidity, and therefore usually carry a higher interest rate when compared to more liquid short-term bonds. The higher return on the long-term bond is the liquidity premium given to the investor because it has a higher investment risk. As a rule, the poorer the liquidity of an investment, the higher the liquidity premium.